In this paper, we identify some of the stylized empirical regularities about India’s IPO market, via a dataset of 2056 IPO.

Contents

1 Introduction

2 Literature Review

3 Institutional Backdrop

4 Methodology:

4.1 Factors underlying Underpricing

4.2 Asymmetric Information

4.3 Fixing Offer Price Early

4.4 The Interest Rate Float

4.5 The Liquidity Premium

4.6 Building Loyal Shareholders

4.7 Merchant Banker Rewarding Favoured Clients

4.8Aggregate volume of issues

4.9Aggregate underpricing

5.Conclusions

6.References

1 Introduction

From the position of finance research, IPO underpricing in the sense of abnormal short-run returns on IPOs has been discovered in almost every country in the world. (Loughran et al., 1994 [LRR94]). This means that IPO underpricing may be the result of basic problems of information and doubt in the IPO process, and it is unlikely to be a fiction of institutional features of any one market. Comparatively little work has been done so far on IPO underpricing in India (Aggarwal, 1994 [Agg94], Krishnamurthi and Kumar, 1994 [KK94]). The primary market in India is unique by world measures in many ways. It has been formed by an unusual history of regulation, the institutional particulars of how IPOs come about are singular, the sheer size and scope of the primary market is huge and the large-scale regulate participation in the primary market by millions of retail investors is unlike that in any other country in the world. The total resources raised on India’s primary market in 1994-95 were 20% of domestic savings (this involves both IPOs and seasoned offerings). Because the IPO market is as essential as a way for resource allocation, it is serious for us to have fixed and final outcomes on the positive economics of the IPO market, this will be the basis upon which the companion paper on normative issues [Sha95a] is built. India’s IPO market also gives a rare research possibility in form of a wealth of data. In the US, roughly 350 IPOs take place per year. In contrast, our dataset of 2056 IPOs is created of all IPOs which come about a period of just 4.5 years, and the IPO market actually experiences over a thousand IPOs per year. This generates a wealth of data which can help answer empirical questions with high statistical efficiency.

The IPO Market in India has been developing since the liberalization of the Indian economy. It has become one of the outstanding ways of raising funds for different developmental programs of different companies.

The IPO market in India is on the boom as more and more companies are issuing impartiality shares in the capital market. With the introduction of the open market economy, in the 1990s, the IPO Market went through its share of policy changes, reforms and restructurings. One of the most significant developments was the taking to pieces of the Controller of Capital Issues (CCI) and the introduction of the free pricing mechanism. This step assisted in developing the IPO Market in India, as the companies were allowed to price the issues. The Free pricing mechanism allowed the companies to raise funds from the primary market at competitive price.

The Central Government felt the need for a control environment having reference to the Capital market, as a few corporate houses were using the abolition of the Controller of Capital Issues (CCI) in a negative manner.

The Securities Exchange Board of India (SEBI) was founded in the year 1992 to control the capital market. SEBI was given the power of monitoring and controlling the activities of the bankers to an issue, portfolio managers, stockbrokers, and other intermediates referred to the stock markets. The results of the changes are obvious from the trend of the resources market which contains rights issues, public issues, private placements and overseas issues.

Prior to the modern economic reforms, a government agency called the Controller of Capital Issues (CCI) had regulatory revision over all capital issues. Before any general issue could come about, the offer price had to be cleared by the CCI. The ďCCI formulaĒĚ was used to count a ďfair priceĒĚ of equity in the light of accounting information. This frequently led to extreme underpricing, and heavy over-subscription. Invertors frequently requested for ten times as many shares as were put up for selling. This extent of underpricing discouraged firms from going public: comparatively few issues came about and debt played a major role in financing programmes. In our dataset, we have only 86 issues which clearly came about under the old regime, i.e. listings from 1 January 1991 to 1 November 1991.

From October 1991 to May 1992, the BSE was confused in a speculative bubble arranged by an illegal diversion of funds from the banking system. This episode is ordinarily named ďthe scamĒĚ. It had two types of results for the primary market: issues priced just before the scam frequently created huge returns from issue date to listing date, and issues priced during the scam often created very poor returns from issue date to listing date. Soon after the scam, on 29 May 1992, the CCI was destroyed, and firms were free to price equity at whatever price they select. There was a intermediate phase after the abolition of the CCI in which extremely few issues came about. The recently founded regulatory agency governing financial markets, the Securities and Exchanges Board of India (SEBI), then took up the role of vetting prospectuses for public offerings, with an eye to ensuring honest information disclosure in the prospectus. SEBI was functional in this role from late 1992 onwards. We can suppose of new listings from the beginning of 1993 onwards as being the product of the new regulatory regime. With the abolition of the CCI, firms were now free to price issues as they wished, subject to several warning. The quantity of public issues coming about per month has gone up sharply in the period subsequent the abolition of the CCI, and the role of debt in financing programmes has reduced. Nevertheless, the post-CCI period is also distinguished by extremely high levels of underpricing by world criterions. Using our empirical evidence, we may be able to shed some light on the factors underlying this systematic underpricing. Nowadays, as in the complete post-CCI period, succession of events in an IPO is as follows: The firm and the merchant banker select an offer price, and make ready a prospectus. This comes about roughly five months before the issue date. The ďface valueĒĚ of shares in India is typically Rs.10, and the difference between the offer price and the face value is named ďpremiumĒĚ. By law, IPOs are forbidden from pricing equity with a positive ďpremiumĒĚ unless this stipulation is met. Either the issuing company, or any company promoted by the owners of the issuing company, should have made profits for at least the most modern three years. For companies which are permitted to price shares above Rs.10 in the light of these standards, there is no barrier in selecting the offer price. There is also a regulatory revision on the quantity of equity which can be sold: the post-issue ownership of the promoters should be bigger than 25%. This prospectus is presented to SEBI for sanction. From April 1995 onwards, SEBI no longer demands the offer price to be precisely selected at the time the prospectus is given for vetting. If the company specifies an offer [rice of x at this time, then the real offer price can be anything between x and 1:2 x. Another constraint on selecting a price early is the Registrar of Companies, which has to be told the offer price 21 days before the issue opens. After SEBI endorses of the information disclosures in the prospectus, a mass media declaring campaign targeted at the lay investors commences. This is roughly a month before the issue date. A consortium of underwriters is frequently put together. Each underwriter ensures to bring forth application forms (either from lay investors, or failing that, from own funds) worth Rs. x, and is paid a fee which is typically 2.5% of x. The underwriting accommodations were compulsory before January 1995, and are now optional. The issue closes four to ten days after it opens. Investors request for shares, and pay amount which is frequently less than the full offer price. If there is over-subscription, then there is an opportunity that the money paid at the time of application may be given back some months hence. In this event, the investor has lost the time value of money for these months. Many banks propose ďstockinvestĒĚ projects which help remove this. This permits the investor to produce a special type of savings account. When submitting the application for shares, the investor provides information about his stockinvest account. The offering firm only withdraws money from an investors stockinvest account to the tune necessitated by the allotment got by him. For issues where the issuer selected to not put together an underwriting consortium, if the subscriptions got fall below 90% of the shares proposed, then the issuing company is demanded to refund applications within 90 days. After the issue closes, the allotment itself comes about.

For issues which are highly oversubscribed, many application forms may yield no allotment. For issues which are highly oversubscribed, the allotment process is frequently hindered owing to the volume paperwork. Once allotment comes about, the investors get shares or refund cheques. Many characteristics of this process are unique by world criterions. The offer price is selected by the firm months before the issue opens, and there is no feedback mechanism through which market demand can change this offer price. Instead of IPOs being sold to institutional investors such as mutual funds, in India, IPOs are immediately sold to comparatively not well-informed lay investors. The procrastination from issue date to listing date is huge in India as compared with other countries. Each of these three factors is likely to produce high underpricing, by world criterions.

4 Methodology:

4.1 Factors underlying underpricing

In this section, we will take a speculative look at the sources of underpricing, so as to define the theoretical backdrop for the empirical results. Underpricing is not a violation of no-arbitrage; it is not a market ineffectiveness which will vanish when some agents become aware of it. Instead, underpricing is structural; i.e. it derives from sound microeconomics underlying the behaviour of investors and firms. Further, there is no elementary interpretation for underpricing. There appear to be six main themes effecting underpricing which may be important in India. An elementary theoretical framework which unites all these factors does not yet subsist. The six factors are also not additive: for example, the ďbuilding loyal shareholdersĒĚ factor may well produce no

supplementary underpricing if the firm feels that the degree of underpricing made by asymmetric information is satisfactory for the purpose.

4.2 Asymmetric Information

The most basic problem of the IPO process is the availability of both ďgoodĒĚ and ďbadĒĚ firms going public connected with asymmetric information between firms and investors. Firms know themselves reasonably well, but investors do not. When information and analysis is expensive, it is optimal for investors not to find out about a firm thoroughly.

This is true of IPOs all over the world, and is likely to particularly relevant in India, where IPOs are marketed to lay investors who know very little about the issuing firm. George Akerlof’s model of the used-car market is a first-rate analogy here. The seller of the car knows its true value, but the buyer will not know the defects, and it is not optimal for the buyer to investigate each potential used-car thoroughly.

Thus, at equilibrium, the availability of bad used-cars or ďlemonsĒĚ suggests that good used-cars have to be underpriced. In the case of the IPO market, at the equilibrium, good firms will have to underprice themselves to compensate investors for the danger taken in investing in a relatively unknown firm. Bad firms will require higher prices (under doubtfulness about firm quality) as compared with their true value. Thus, under asymmetric information, the primary market is the conduit for a systematic subsidy from good firms to poor firms. While such situations happen in different fields of economics, they are extremely significant in IPOs as the value of firms going public is frequently in the growth possibilities which the firm may hope to capture, rather than in fixed assets and a clear track record. The greatest strength of an IPO is frequently likely to be in the thoughts and creativity of the promoters, and not the fixed assets of the firm (which are relatively easily measurable and quantifiable). Firms would resort to numerous signaling strategies to attempt to say their true value to investors. We will not explore these strategies here; for our goals it suffices to see that to the extent that this basic informational asymmetry

subsists, firms going public would have to underprice themselves. In a classic article, Rock, 1986 [Roc86] investigates the role of the ďwinner’s curseĒĚ in IPO underpricing. Rock’s model has two types of investors: those who are quite informed about the true value of the firm and those who are completely ignorant about the true value of the firm. The quantity of shares being sold at an issue is fixed, and informed investors will only try to buy shares when issue is relatively underpriced. Consequently ignorant investors, who do not know whether a specified issue is underpriced or not, suffer from a winner’s curse: they receive all the shares they wish of the poor issues, and they receive small allocations of the good issues. This kind of phenomenon is obviously at work in India. In Rock’s model, this unfavorable selection will constrain firms to underprice themselves at equilibrium to remain attractive to uniformed investors.

4.3 Fixing the Offer Price Early

The firm sets the offer price at time 0, and the issue opens at time T. Let us fancy that there is a ďshadow stock priceĒĚ (which is not known to the world, since listing has not yet come about). Nevertheless, this notional market-clearing stock price vibrates from day to day, and even if the firm has an exact notion of the price at time 0, it would be afraid of a drop in stock prices by date T which returns the public issue unattractive. A famous instance of such danger is the (seasoned) offering of British Petroleum, which was priced just before the NYSE crash of 19 October 1987. Firms are likely to be risk-averse with connection to the prospect of issues failing.

Consequently they would underprice in order to prevent this opportunity. The protraction between selecting an offer price and the issue date has reduced in some sense with the new SEBI policy which permits firms to select a price band at the time of vetting the prospectus instead an exact price. On the other hand, the Registrar of Companies still demanded a precise offer price 21 days before the issue opens and the price band which SEBI permits is quite narrow. Consequently the IPO market is still distinguished by an early choice of offer price. Under the generally accepted model of stock prices, the geometric brownian motion model, uncertainty about the future stock price blows up at the rate ¬†as the delay T increases, so the degree of underpricing will worsen as T increases. This picture is consistent with a collation of the international evidence on IPO underpricing, taken from Chowdhry and Sherman, 1994 [CS94] (who, in turn, cite Loughran et al., 1994 [LRR94] as the original source).

The procrastination between date of setting offer price and the listing date clearly seems to be a significant factor here. On the other hand, this table serves to remember us that IPO underpricing resists simple interpretations, for instance, something occurred in Japan on 1/4/1989 which decreased the extent of underpricing from 42% to 15% (we will come back to this special episode in the companion paper on policy issues [Sha95a]). Similarly, the dissimilarities in agreed arrangements make a dissimilarity of 43 percentage points in Finland for the identical three month delay. Evidentially, there is much unexplained discrepancy in the magnitude of underpricing for the elapsed time.

4.4 The Interest Rate Float

The issuing company verifies the application money for a few months. Even if stockinvest were widely used, the interest rate on stockinvest accounts of around 12% is quite low. At equilibrium, markets would compensate investors for this low (zero or 12%) rate of return, though underpricing. A back-of-the-envelope computation will help show up the magnitudes involved. Believe an issue of size x appears, where half the offer price is paid at the time of application, think it is over-subscribed three times, and think the issuing company verifies this application money for three months. Using a nominal interest rate like 18%, the interest earned by the issuing company is around of 7% of the issue size. Thus the interest rate float reasoning may account for underpricing of around five to ten percentage points.

4.5 The Liquidity Premium

Investors who request for public issues lose liquidity on the amount paid at issue date. At equilibrium, markets would compensate them for this by paying a liquidity premium, which would illustrate in IPO underpricing. The subsistence of such a premium goes from finance theory. It is not easy to empirically test whether it is indeed at work in IPO underpricing in India, and to measure its role. This is particularly true in the light of the ex-ante unpredictability of the delays from issue date to listing date.

4.6 Building Loyal Shareholders

Firms may have a motive to underprice when they hope to return to the capital market to elevate further resources at a later date, via a rights issue or a public issue. In this case it helps the firm to abandon customers at the IPO underpricing with ďa good taste in the mouthĒĚ.

4.7 Merchant Banker Rewarding Favoured Clients

The cooperation between the merchant banker and the company going public is typically a one-short interaction, but the merchant banker is in a recurring game with many of his large clients, particularly the large institutional investors. In this situation, the merchant banker has a motive to underprice as a way of favouring his established clients (Baron, 1982) [Bar82].

While this would offend the interest of the issuing company, this may often not influence the profit maximization of the merchant banker directly. This is particularly true in a situation where abstract statistics of the degree of IPO underpricing for each lead manager are not readily available to firms going public. While the microeconomics supporting this thought is irreproachable, its empirical meaning may be limited. In the US, this offer has been tested by measuring the extent of underpricing saw when underwriters themselves go public (Muscarella and Vetsuypens, 1989 [MV89]). This has discovered to not be soundly dissimilar from the overall average underpricing.

In the reminder of this paper, our purpose is to set up the stylized empirical regularities about India’s IPO market.

We will begin by establishing of aggregate underpricing. Beyond the first trading day, on which underpricing is measured; we take up the questions of returns and trading frequency after listing date. The paper ends with a summary of the results.

4.8 Aggregate volume of issues

Our sample is built of all new listings on the BSE from 1 January 1991 to 15 May 1995. We would like to know the time-series properties of the number of issues per month, but our picture is likely to be clouded by ďedge effectsĒĚ: of the issues which took place in 1990, we are more likely to observe the issues which experienced greater delays from issue date to listing date, and of the issues which took place in the recent past, we are more likely to observe the issues which were listed relatively swiftly. This leads us to the following graph, where the x-axis represents the issue date.

This shows a dramatic increase in the number of IPOs per month, from the region of 20 a month before the abolition of the CCI in May 1992, to the region of 80 a month from late 1993 onwards. The picture obtained via the value of IPOs per month, in millions of rupees, is similar.

One strong factor clearly at work in this time series is the sheer time trend. The regression shown below suggests a compound growth rate of 5.86% per month over this period. The average inflation rate over this period was in the region of 9% per annum.

Beyond the time trend, we would expect the value of IPOs in a month to respond to secondary market fluctuations, so that more resources are raised from IPOs when returns on the market index have been good. We find that the following model is good at capturing some of the time-variation of the value of IPOs per month (t stats are shown in brackets).

Let us represent monthly returns on the market index as r, and let us use the notation r1 for the returns of the previous month, r2 for the returns of two months before, etc. The explanatory variable used in the regression is r2 + r3 + r4. There is a little lag structure here, in the sense that the coefficients of the unrestricted model in r2; r3 and r4 (not shown here) are not all equal, but we ignore this in the interests of parsimony. This model implies that the value of IPOs in May is influenced by stock market returns from 1 January to 31 March. Our estimation results suggest that while this effect is somewhat weak statistically, it is significant numerically. For example, if returns prove over these three months prove to be 10%, then it has an impact in logs of 0.0884, i.e. IPOs worth 9.2% more than would otherwise have been the case. The timelags seen here are quite short – this may suggest that firms do not strongly plan IPOs in response to fluctuations in the market index. There is always a pool of companies who have obtained SEBI approval, and their precise choice of the issue date is influenced by stock market returns of the immediate past.

Stock market returns may also affect the very IPO

planning process via longer lags, but our sample runs over too short a period to identify this with statistical precision. Could variations in ex-ante volatility of the BSE Sensex influence the decision to launch an IPO? Thomas, 1995 [Tho95] finds that while the volatility of the BSE Sensex is autoregressive, the forecastability of volatility is most pronounced in daily and weekly returns – after controlling for regime shifts and budget-related seasonality, monthly returns are essentially homoscedastic. Hence the time-series of the aggregate value of IPOs in a given month may be affected by the seasonality. Our dataset does not permit examination of this problem.

4.9 Aggregate Underpricing

We now turn to IPO underpricing. Of the 2056 IPO’s that we see, 1819 gave positive returns from issue date to listing date. The percentage returns from issue date to listing date have the following qualities:

The full dataset demonstrations mean underpricing of 105.6%, and if issues are weighted by issue size, the mean underpricing comes to 113.7%. To limit our sensitivity to extreme observations, we trim the highest 2% and the lowest 2% of observations and re-count these measures using the middle 1974 observations: this gives us a having of the

To limit our sensitivity to extreme observations, we trim the highest 2% and lowest 2% of observations and recalculate these measures using the middle 1974 observations: this gives us a halving of the criterion deviations, and an average underpricing of 87.6%, or 96.3% using weights proportional to issue size. These total statistics are, on the other hand, of relatively limited value because of the long and variable intervals from issue date to listing date.

Somewhat under half the issues have a listing protraction between 10 and 13 weeks, and the reminder has listing protractions worse than 13 weeks. This means that the IPO underpricing, counted as the sheer returns seen between offer price and listing price, is affected by heterogenous listing delays, over periods when the market index has been performing very differently. This elementary averaging slights the value of time, and instabilities in the market index, and is hence not a good method to measure IPO underpricing. We will hence deviate from the literature in expressing underpricing as returns per week. We will additionally show this in excess returns form, i.e. returns per week on the IPO in excess of returns (per week) on the market index, where returns on the market index are counted between issue date and listing date. This gives us the following summary statistics:

Both the above tables display an extremely high degree of underpricing by world criterions. This fact comes across in all the various procedure of calculation shown here. The simplest summary statistic that we can take away from this is: on average, IPOs yield a huge 3.8% per week in excess of returns on the market index (which yields 0.45% per week on average). This measure of IPO underpricing, of 3.8% per week in excess of rM, has good strong statistical precision: the 95% confidence interval ranges from 3.6% to 4%.

5 Conclusions

Our findings may thus be resumed as follows:

1. India’s IPO market is distinguished by pervasive underpricing. In our dataset, on average, the price at first listing was 105.6% above the offer price.

2. The commonest protraction between issue date and listing date is 11 weeks, and it is highly variable. This protraction is strongly associated with issue size, where bigger issues affect to have shorter protractions. There is some evidence that the listing delay has reduced over the years, but there has been no improvement in 1995 as compared with 1994.

3. Because the listing delay is variable, it is wrong to use elementary averages in expressing IPO underpricing, this would be clubbing together returns obtained over different lengths of time. Because this protraction is long, it is essential to measure returns on IPOs in excess of returns on the market index. Hence we focus on the weekly returns on IPOs, in excess of weekly returns on the market index. We discover that the average IPO underpricing comes to 3.8% per week by this metric.

4. The inter-company differences in underpricing are notably hard to model. We discover that issues with offer price above face value have much lower underpricing, but the underpricing gently grows with the offer price. Underpricing is very high amongst the smallest

issues – it drops sharply in the bottom quartile by issue size and gently grows as the issue size becomes larger beyond the bottom quartile. Returns on the BSE Sensex in the past impact underpricing with the same lagged relationship noted above. Ultimately, the ratio of issue size to project outlay is negatively associated with underpricing.

5. The average long-run trading frequency of IPOs is 74%, which is much worse than the A group companies, which have an average trading frequency of 94%. The trading frequency of IPOs is slightly higher after first listing, and settles down to the long-run average within the first ten days or so.

6. In all, the price at the close of the very first day of trading is a nearly objective prediction of the price 400 trading hence, barring the instabilities in the market index.

7. We propose a new method of measuring the process of price finding, and discover that markets are strongly ďlearningĒĚ the correct prices in the first few days, but the price finding process goes on to a lesser extent for as long as 1.5 calendar months. During this initial period, and particularly during the first five trading days, mispriced assets are likely to subsist.

The Indian economy is in full form, much like the Indian cricket team. According to specialists Indian companies are flocking to the stock markets in droves to increase capital. It has come into the notice of The India Street that India has leapfrogged its method to reckon seven among the world’s hugest IPO markets in the first eight months of this year. In 2006, India was at 14th position. Besides, share of Indian global IPO proceeds is now 3.5 per cent, compared to 1.7 per cent in 2006. Actually, IPO mobilization so far this year, at $6.4 billion has already out counted the $4.8 billion increased last year. I suppose, the major factor behind this tremendous performance by India were DLFs $2.26-billion IPO, the largest ever by an Indian company, Genpact $568 million IPO, Idea Cellular $555 million IPO and Power Finance Corporation $226 million IPO. According to sources, number of IPOs is going to hit the Indian market in the coming months particularly from retail and infrastructure companies. Reason to be marked here is that the flurry of IPOs is driven by the extended bull run in the Indian equity markets. No one will discuss with the fact that the primary market ordinarily gives better returns as compared to the secondary market in a rising market scenario. This very much means that the retail and institutional interest in IPO’s. Thereto, interest rates have become hard over the last six months, increasing the cost of borrowed money and insurmountable companies across the board to approach the primary market for economical funds in order to finance their expansion plans. Interestingly, there is more action to come in the near future, really there are a big quantity of unlisted companies that need capital, particularly in sectors such as real estate, media, retail, infrastructure and banking.

There is another important factor that is playing an outstanding part in fuelling this boom. Over the last two or three years, private equity invertors have taken quite a bit of stakes in technology, media, telecom and pharma companies.